Understanding RRSPs

Benefits of RRSP Investing

While most individuals recognize the benefits of investing in a
Retirement Savings Plan (RRSP), many do not exploit its unique
advantages to their fullest potential. There are three primary benefits
to investing in an RRSP:

Tax Savings

Contributions to an RRSP are deductible for tax purposes within
certain prescribed limits. In the year a contribution is made to an
RRSP you can choose to deduct the contribution from your taxable income.
This deduction reduces the amount of taxable income and thus the tax
payable. The actual tax savings will depend on your marginal tax rate.

The table below outlines the amount of tax saved, and the after-tax
cost of a $1,000 RRSP contribution based on various marginal tax rates.

Tax-Deferred Compounding

The most significant opportunity offered by an RRSP is the tax-deferred
compounding of income earned within the plan. The term "tax-deferred
" refers to the fact that all income earned within the RRSP accumulates
tax free until withdrawn.

If you have $10,000 to invest and have the choice of making an
RRSP contribution or not making an RRSP contribution, consider the chart below,
which shows the difference between investing the money inside and outside
an RRSP (tax-deferred versus taxed). Remember, if you invest the money in
an RRSP, you will save $4,000 in tax (assuming a 40% tax rate). Therefore,
a $10,000 contribution to the RRSP is comparable to a $6,000 investment
outside the RRSP, assuming the tax savings are reinvested.

As you can see from the chart, you would be better off contributing to
the RRSP. The question is, how much better?

To determine the RRSP advantage we have to convert the RRSP value to
an after-tax value. To provide this comparison, let’s assume you
will withdraw the $21,589 accumulated by the 10th year and pay tax at
40% on this income. In the unlikely event the RRSP is actually collapsed
in the 10th year, you would still have $3,364 more by investing in the
RRSP. Allowing the money to remain in the RRSP after the 10th year will
further enhance the benefit to you.

Income Splitting

Utilizing income-splitting strategies between spouses can provide significant tax savings. One of the most simplistic, yet effective methods of income splitting between spouses is achieved by contributing to a spousal RRSP. The objective of this strategy is to provide both spouses with similar retirement incomes and thus similar income tax rates in retirement.